Monday, November 21, 2005

When One plus One Equals Not-Quite-Two

It’s not like they aren’t trying.

The Sears Essentials store, a by-product of Eddie Lampert’s ambitious attempt to shmoosh two aging retailers together and come up with a store people actually want to shop, is not, as I have discussed before, all that bad.

Recall that “Essentials” (an appealing but bizarre name, when you think about it: this is not a convenience store we’re talking about, but a big old apparel-to-corn flakes general merchandise store) are refurbished ex-Kmart locations rebranded with the Sears logo and Sears-branded merchandise added to the mix.

Having visited one store in the upper reaches of rural Connecticut (see “Eddie to the Rescue,” September 9, 2005), I wanted to check out its brethren in the freeway-clogged suburbs of Los Angeles.

I found one on the outskirts of Corona off Interstate 15, in a very typical this-used-to-be-a-decent-area old Kmart location. It was a relatively easy store to spot because of the large Sears Essentials sign on the building…and because of the rather desperate looking young Sears employee standing on the sidewalk waving a “Sears Sale!” sign at passing motorists.

Now that I have seen them on both coasts, I think I can safely generalize about them.

For starters, the Sears Essentials stores are clean, well-lighted places with bi-lingual signage and plenty of merchandise—nicer by far than the old Kmart you knew and did everything in your power to avoid entering.

The Sears house brands—Craftsman tools and Kenmore appliances—give the stores a flavor entirely different from the previous failed occupant, while the electronics department is now bigger and more coherent than the old Kmart version, with row after row of flashy TV screens along the wall. And there is plenty of Martha Stewart merchandise everywhere, from towels to $250 artificial Christmas trees.

The theory behind Essentials is that by expanding distribution of widely recognized (and still trusted) Sears house brands into Kmart locations that previously failed to generate enough business to justify the lease payments, Sears Holdings would generate higher sales and transform a liability—a long-term lease in a mediocre location—into an asset. The basic idea being that one plus one would equal three, maybe four.

Indeed, like its counterpart in northeastern Connecticut, this L.A. Essentials store had shoppers—not nearly so many as the clean, well-lighted, terrifically merchandized Target store a few miles away, but it had some shoppers.

Yet as I walked around the store and saw the merchandise placed with its usual Sears cluelessness, I found myself understanding why the whole thing seems so inconsequential: by opening Sears Essentials stores in old Kmart locations, all that has happened is…Sears has opened a bunch of new, mediocre stores.

That’s all.

Meanwhile Target, Wal-Mart, Costco and the rest continue to open well-merchandised stores with great prices where people actually want to shop, without requiring employees to stand on the sidewalk waving “Sale!” signs.

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

24 comments:

First, the combined company has only existed for 8 months. It's fairly difficult for even a well managed retailer like WMT to make significant changes in such short periods of time (look at a 5-year chart of WMT to see how having good traffic has impacted their stock price). Perhaps the Sears team should be given just a little bit more time.

Second, a look at the financials so far might be helpful. Though we are only 2 quarters into this company's history, there is a dramatic improvement in EBITDA margins (I know you are going to say using EBITDA is a terrible measure -- and I would normally agree, but capex is much lower now than at the old Sears -- something to debate, but that's the strategy being employed right now). On a sales decline of 1.1% (pro forma comparison as if the combined company existed last year), EBITDA is up 19% this year.

Third, I challenge you to find one Sears investor who thought the retail operations would be fixed within 6 months. The thesis among the Sears investors I know is that 1)Sears was terribly managed before the merger, 2)improvements can be made over time using the resources of the combined company to generate significant cash flow, and 3)that cash flow will be reinvested at higher returns on capital than currently exist at the company.

I'm not convinced that the experience of walking through 2 stores changes the general, long-term investment thesis.

I'm not sure Wal-Mart's stock price over the last 5 years is the appropriate measure of how they've been doing as a business given that most large capitalization growth stocks (including Wal-Mart) were substantially overpriced in the late 90's.

How does Wal-Mart look versus 5 years ago in terms of number of stores, sales, net income, cash flow from operations, return on equity and other such measures?

Kmart stores in the chicagoland area are still plagued with massive banners draped over the side of the store advertising 50% off.

No, 6 months is not quite adequate time to turn an aircraft carrier around, the problem is the brand continues to sink. Shopping at Sears means what?

Shopping at WMT means low-prices. (and a dismal environment that is becoming a negative societal connotation - not good for a brand)Shopping at TGT means cheap-chic (and an aspirational environment that is reaching all socio-economic brackets)

The combined company has only existed 8 months, but the stores have been around 40-plus years. And the point is, the so-called new stores don't look a heck of a lot different than the stores that failed to compete with Wal-Mart and Target and Costco in the last dozen years.

JC Penney, on the other hand, turned around its aging store base but only after hiring Alan Questrom, a real merchant, and letting him pick his team, and then spending the money to refurbish the stores. You could visit the stores and see the changes fairly early in the turn.

If you're not going to see the turn in the stores, you're not going to see it in the numbers.

As for the reduced capital spending--well, if you're not going to spend the money you will never see the turn in the stores.

And regarding the shareholder base...you are right. The hedge fund guys in this deal don't expect a quick fix.

I recall Marty Whitman, who I regard as the smartest of the bunch (no offense to anyone), saying something like "Ask me in 3 years" how the Sears/Kmart merger is going.

I think most would agree that buying Sears and then immediately increasing capex spending dramatically would have been a foolish move. It might be best to assess which locations deserve the spending before blindly increasing spending on all the stores. These decisions take time.

As long as we're introducing anecdotal evidence, the KMart store in Santa Barbara, CA is a terrific store that is constantly busy. It was recently remodeled and people love it. I'm not going to generalize about all the stores based on that one though.

As for Whitman being the smartest of the bunch... be careful. Don't you live among all these hedge fund guys? You might not get invited to the holiday parties with that talk.

While 6 months may not be enough time to judge the full impact of a merger, the current time period is THE critical period for retailing. Mr. Lampert would not be content with an "Oh well, we blew the 2005 Christmas season. We'll get'em next year." 2005 is critical for Sears and THIS Thanksgiving weekend is the critical first step of the season. An important question is what will get the thousands of Target, Costco and Wal-Mart shoppers to give Sears a try given that so many have found their shopping needs satisfied by the Big 3. The following ad ran in the San Francisco Chronicle. If this is what they are planning as a way to get shoppers in the stores, I think they might be disappointed. Just my opinion. Any other views?http://personalshopper.sfgate.com/RopAds.aspx?adv=2401

Dunno if I can buy into your JCP-transformed-its-iffy-locations-so-quickly-under-Questrom-in-comparison-theory, to coin a phrase. When Questrom took over at JCP, the department stores were comp'ing down only 2% or so. EBITDA margins had plunged to 3% in the solitary year 2000 from 7-8% the few years prior.

They had basically been getting $130 sale per sqft for years. I agree that it didn't take too long for the stores to start to look better, but the boxes didn't suddenly explode with traffic. He got there in Sept of 2000 and in 01-02 sales per sqft were a whopping $133 on 3% positive comps with a huge marketing budget. EBITDA margins ticked off the 00 peak but was still way below 99 and below basically everyone else in the industry (no Sy and Marcy, not you). Pretty darn good and happy stock by not JCP = JWN or even JCP = KSS in 16 months (not even close).

The real jump came in 02 when sales /sqft popped to $140, but EBITDA (for the department stores) was still below both of the two years prior to Questrom taking over (comps up 2.6%). This was still a very low productivity, low margin retailer inching back into the game. And oh by the way capex for the dep't stores was down in both 01 and 02 and below segment depreciation (though not by Lampertesque amounts) both years.

2003 was an even smaller improvement. With sales/sqft basically flat at a still-anemic $143 and EBITDA of $1.15b still below 98-99 levels. Three years late and EBITDA margins were just nipping at 6.4%.

My point in all this is that yes Arizona and Stafford and wider aisle and the JC Penney towel and Celine Dion perfume, but this is NOT (in my anonymous view) a story of a slingshot rebound from Paul Harris to Chicos. JCP started to look a little better but still occupied crappy malls or worse and the traffic came slowly and mildly no reall fast and furious (they had a couple of other good things happen along the way, like patching up catalog and Eckerd). The converted KMRTs to SE have a lot of the same features -- they look a lot better but not surprisingly haven't suddenly turned into Target.

Yes, none of this hits the argument that that these things won't improve or even stabilize traffic *at all*, namely because Lampert is taking a margin-first capital-restrictive price and spend approach that will prevent even a modest JCP type revival. But the idea that the converted stores look better (which they do) but don't have traffic because the RE sucks (which is true in some cases and false in others), and thus you can already tell it is doomed unlike the ricochet JCP saw just doesn't ring true to me.

I would have to say it's going to take more than a cosmetic makeover to turn around Sears/Kmart. I would guess that people shop at WalMart because shoppers know they will find cheaply priced products.

I'm not sure how much power Sears has over its suppliers, but as many of you may know, WalMart dominates many of its suppliers. WMT also has unique, yet sometimes controversial, employee policies. WalMart has also been on top of the supply-chain logistics with things like the hub and spoke distribution network.

WMT's control over the costs is what I'd imagine allowed the company to offer cheaper products and establish its current position. I'm not sure how Sears/Kmart's model works, so perhaps it's problem is more than what I've suggested.

I'm in the middle of reading Marty Whitman's "Value Investing: A Balanced Approach" and his book can give an OPMI (outside passive minority investor) ideas about how a company's assets dictate value and its perception among investment constituencies.

A cursory look at SHLD's balance sheet will show you that almost 20% of its total assets are tied up in both intangibles and goodwill. Sears has some aging brands (Kenmore, Diehard, Craftsman, et. al.) that, as assets, have outlived their "value" to SHLD's investors.

I think Mr. Whitman would ask, what are SHLD's assets REALLY worth? Are the name brands of SHLD really worth the amount given on its balance sheet? I doubt he would think so. I think a key question to be asked is this: How will SHLD begin to change the "quality" of its resources as opposed to the "quantity" of its assets?

Another issue would be the property that SHLD stores sit on - Mr. Whitman would likely ask, what are SHLD's real estate holdings REALLY worth to a private or control investor (i.e., what would be the private market value of SHLD's real estate)? In essence, are SHLD's real estate holdings producing income? Yes, but very sluggishly, in my opinion.

Value investors will get on board with SHLD only when they perceive that Mr. Lampert and company are changing both the quantity and the quality of SHLD's assets for long-term wealth creation. I'm not sure how SHLD's off-balance sheet debt is contributing to creating wealth for SHLD's shareholders, though, but then again, I'm just an observer making an opinion and I could be wrong...

It's actually kinda tough being a value investor in a strong market. Traditional "value" methods of screening for companies will rarely pick out winners in current markets. And if you look at it relatively, SHLD looks more of value play than stocks like WMT.

SHLD's enterprise value is almost $22 billion. It's current assets amount to about $14 billion, so if you liquidated all of its assets (including PP&E and excluding intangibles), you'd probably have about $25 billion.

Now consider WMT, which has an enterprise value of almost $240 billion. Yet it only has about $40 billion in current assets. And if you fully liquidated all of its assets, you'd probably end up with half that of its market value.

Value investing is great and all, but it's so hard finding candidates that meet all the criteria. I guess it really depends on how you define "value." Besides looking at their assets, you'd also have to consider their liabilities and obligations. And compared to many other stocks out there, SHLD looks like a pretty decent value play. SHLD just needs to make sure it can get rid of their inventory, enough to meet its current liabilities.

Alex,You know what... you're probably right. When Mr. Buffett is buying companies like WalMart and Anheuser Busch, you'd really have to wonder how he's measuring value or intrinsic value. I guess he really does weigh ROE greatly into his valuation matrix. But I would've never guessed that he'd go for WalMart... he's probably using some revenue ratio to value that play.

The real money is in looking at some distressed companies. Do alot of homework, do some credit analysis, asset analysis, free cash flow analysis, probability of a turnaround, management issues, etc. And with some luck, maybe you'll find some valuable treasure.

Sam, this kind of deep digging - I don't have time for it. I'm not a professional investor, I have a day-time job. I just see a stock market that is so expensive that by any measure there's no returns to be had from it unless we all collectively lose our minds and drive it to Nasdaq Y2K valuations. I'll wait. This will change, people will hate "stocks" again, driving them to the point where I'll pick and choose like a spoiled kid.By the way, I lost a lot of respoct for Buffet when he began touting his dollar shorts at the end of last year. Not only the US$ was a screaming buy at that point, he stuck his nose into Forex, which was clearly not his cup of tea. Ditto for Mr. Gates. Small Investor Chronicles

Alex,You've spoken the true words of a wise investor. Yeah, you shouldn't be deep digging, and you shouldn't chase stocks. You seem to have your head on straight, and I admire your investing discipline. Stick to your risk tolerance level and do what works for you. I definitely want to see how this holiday season turns out, so I can get a better idea of where we could be headed.

Sam, thanks for the kind words, I'm trying to do my best (blush...).I was really amused to see WMT dip below the price I paid for it back in 1998 (disclosure: I don't own any now). Even at that price it was too expensive to own, although those so inclined could (and some did, apparently) make a few bucks trading it - the stock looked oversold and hitting some pretty stiff support.-Alex.

Well SHLD got a deal for Orchard Supply, just not what they thought they would get. SHLD takes a dividend and a note payable. The note payable seems to be bridge financing until "high yield market conditions improve".

For this deal, that might be a long ways off, perhaps they can get 1% fed funds again. We should probably consider this note payable as very equity like.

A) You're right; there is a dearth of value plays in the markets today. The pickings are pretty slim, especially during this time of the year when stock market rallies are the norm. On second thought, however, one could look at issues that are being sold off for tax losses and "window dressing" by portfolio managers as potential value plays going into the New Year.

B) I also agree that liabilities are just as important as assets when looking at "value" plays since, as you mentioned, the concept of "value" is relative according to how one analyzes a company's balance sheet.

C)Regarding distressed stocks, I think back to some stocks that recently came out of bankruptcy (i.e., Health South, Conseco, et. al.) that have done quite well since their completed reorganizations. The thought of investing in distressed companies, while very risky (I wouldn't touch stocks like that because those stocks do not fit my investment style), can be very lucrative to those investors who can and do understand the bankruptcy process and how creditors act in their own interests during the proceedings.

By the way, being that this is a holiday and all, I want to wish you and your family a safe and happy Thanksgiving.

I guess you could say that I am thankful that posters like yourself are willing to share their insights with speculators like me. Again, keep up the good work - hopefully, one day, I can return the favor and share something a little more insightful than my usual ramblings...

Thanks for the kind words. I don't really come to Jeff's board to claim I know so and so. I'll be the first to claim that I don't come close to knowing everything about investing... I still have much to go. I actually like when you go off with your comments, because it keeps me on my feet. I'm sure people like DaleW feel the same way (I thought he'd be all over the retail topic, but I suppose he's restricted or something). I come here to read comments from people like him too.

Anyway, sometimes you do point out several good things. Like you had said before, you're learning as you go. I know how that feels; investing is a learning process, and it's fun talking about various strategies and stuff.

Happy Thanksgiving to you too and enjoy that turkey. I'm gonna stuff myself with turkey and then take my turkey nap afterwards.